If you owe the bank £100, that's your problem. If you owe the bank £100 million, that's the banks problem.

Archive for the tag “bonds”

Britain has always been the odd one out within the EU; declining to adopt the euro, going against general European opinion in “liberating” Iraq and generally having a poor reputation with the rest of Europeans. More recently David Cameron vetoed the European Fiscal Compact last year (tightening fiscal rules for countries in the EU) while Britain’s foreign secretary was excluded from a group of eleven European foreign ministers in trying to come up with a solution for the Euro crisis over the last year. Furthermore, Britain is also very hard to fit into the general pattern that has emerged in Europe, that of prudent northern nations and reckless southern nations. The likes of Germany and Holland lived within their means and are now footing the bill for the likes of Greece and Portugal that are drowning in their own debt and cut off from the international markets.

Britain would be considered one of the Northern nations geographically, but has finances more like those of Spain (another troubled country). For example, a high budget deficit to GDP ratio of 8.3% resembles Spain’s slightly lower ratio of 6.8% rather than Germany, who boast a far lower deficit to GDP ratio of 0.3%. But while Spain are facing talks of a bailout and bond yields near the levels of those that had to be bailed out (5.9% on ten year bonds), Britain are comfortably paying extremely low yields on their 10 year bonds, at 1.86% recently. Some argue this is because Britain holds the confidence of the international markets, as it still holds its AAA credit status, had a budget deficit reduction plan (albeit rather unsuccessful so far) and importantly has its own currency – allowing it to depreciate externally.

A graph showing the difference in the UK and Spain’s 10 year bond yields.

But just because Britain’s position within the EU is hard to place, it doesn’t mean they should leave, so next we will look at the positives and negatives for staying in the EU. A big positive is that the UK is part of the world’s largest single market, with free trade within the EU boosting the UK’s exports and imports (with protectionism not allowed). For example, 51% of the UK’s exports are to the rest of the EU, accounting for around £200 billion. Another benefit is the free movement of labour within in the EU, which has seen 3.5 million jobs created that are directly or indirectly linked to the EU. This also works the other way as Britons are allowed to move freely to different countries to find work. Both these measures help in cutting the regulation for firms and individuals as well, that for too long strangled the opportunities for business between different countries in Europe. For example the 27 different currencies made trade between multiple countries much more complicated and created instability as currencies could appreciate or depreciate too readily. Lastly investment is a bonus, as the UK is a good entry into the rest of the EU market for foreign firms, with the UK receiving £28 billion in 2009 from FDI. That is not to mention the increased togetherness of Europe now, with war highly unlikely and diplomatic relations at an all time high. But eurosceptic’s will argue differently, pointing to the current-account deficit of £33 billion in the first quarter of this year (a deficit to GDP ratio of 2.1%)) and the ever increasing contributions to the euro budget that outweigh, some think, the benefits that Britain receives.

UK FDI inflows in 2010 near $50 billion.

I would argue that being part of the EU has benefited Britain over the years, but that the real question is whether they should leave now? Britain is facing the costs of helping to bail out countries that have struggled to depreciate while being part of the euro, a currency that Britain doesn’t actually use. These bailouts have stemmed from a euro crisis, which is having a clear negative effect on Britain’s exports, investments and confidence. A full scale break-up of the EU would have dire consequences on Britain, as the nation’s banks are heavily linked with the rest of Europe and could conceivably collapse as part of a domino effect.

Showing the exposure of UK’s banks to the Eurozone.

Even considering that the EU doesn’t implode and instead moves towards further integration, is that where Britain wants to head towards? The country is already an outsider for having a separate currency; any further integration would surely lead to the adoption of the euro. It would also mean more loss of sovereign powers, as budgets would be decided in Brussels, debts spread across the whole union and credit transferred across countries to those nations that need it most (as what happens with the USA and its states). A country already angry at the loss of sovereign powers to the European High Court would be very reluctant to transfer even more control to central Europe. Another problem of further integration is that many believe this could only happen by shrinking the union itself. If so, the dropping of some unwanted countries would reduce the markets open to Britain substantially, reducing the benefits (more trade) of the single market and making the idea of staying in the EU more unattractive.

The nation’s future with the EU is clearly in doubt, with both possible outcomes leading to a big change in the relationship the country shares with the rest of Europe. For years it has gained all the benefits of being partly integrated and now it is facing all the problems. A referendum seems unlikely in the near future, as the public’s views is tainted with all the current media storm about the euro crisis, while the government would do better than to revolve the next election on whether the country stays in the EU.

So for now Britain will remain on the sidelines, as Europe moves towards an uncertain future, but sooner or later the nation will have to make a choice.

A credit rating is supposed to assess the chances of a firm or country defaulting on its debt. These are decided by credit rating agencies, of which the biggest three are Standard & Poor’s, Moody’s investor service and Fitch ratings, of which most people would have heard of at some point in the news. The credit rating of a country can have an impact on who buys their debt, which is sold using government bonds (Glorified I.O.U’s). The top rated countries belong to North America and Europe, while countries in Africa, South America and Asia are downgraded due to political instability and lack of modern infrastructure (i.e. transport, healthcare etc).Standard & Poor ratings

So what does the AAA credit rating (the highest rating a country can be awarded) actually bring to a country? The rating means it is believed this country can pay its debts (aka is reliable), which means the country has a better chance of borrowing money (through bonds)and also borrowing it cheaply with vice versa for badly rated countries. Each credit rating agency can disagree though, with Standard & Poor choosing to downgrade USA to AA rating, but the other two agencies deciding against it. Surprisingly, some might say, China and Japan do not have AAA rating. Japan lost theirs in 2001 after poor economic growth and an ongoing problem with deflation, which is ironic because Japan as the biggest net creditors are rated lower than the world’s biggest net debtors, USA. With China, the world’s second largest economy, it is harder to see why they do not have the top ranking. But the fact is China hold a lot of debt and though debt to GDP ratio looks a comfortable 20% this climbs much higher to around 80% when local government debt is included. Local governments borrowed money from banks during the financial crisis, with the knowledge that the national government could bail them out, but there is uncertainty over the amount of debt and whether the national government can do as they say, which leads the rating agencies to decide against giving out AAA credit ratings.

Showing China’s hidden debt, which when other factors are considered rises to around 70-80%

There has been recent rating changes in Europe, with France downgraded by Standard & Poor (though they kept their AAA rating with the other two agencies). This was followed by downgrades for Spain, Cyprus, Portugal, Austria, Slovakia, Slovenia and Malta by Standard & Poor. The UK was also warned recently by Moody’s that they could face a downgrade in the near future due to poor growth, rising debt and exposure to the Euro crisis. The USA lost its AAA credit rating by Standard and Poor because of rising debt and an inability to decide on future action to lower their deficit. Are these countries now less reliable?

Japan lost its AAA credit rating and was hardly affected; the government borrows mostly from the public, so the rating did nothing to harm the economy. The same thing happened to the USA, but more was expected to happen, they rely heavily on selling their treasury bonds to the World, which before the downgrade was basically known as risk free, with prices even going up during the financial crisis as markets looked to invest in something rock solid. But even after the downgrade, markets still believe in the US, and still believe there is little risk in buying their debt. This is because, the sheer size of the USA means if they were to ever really default, it would topple the capitalist market, as each country is inter-connected. The Euro zone could only just about survive Greece defaulting, so it is hard to imagine the enormous impact a US default would bring. This fact keeps the USA safe from the effects of downgrading, with many criticizing Standard & Poor for merely pulling a publicity stunt, as in reality the US debt is still seen as risk free as it ever was before.

If America were to ever default…

So is the AAA credit rating flawed? The answer is yes in many ways. The three biggest credit rating agencies are all US based, with accusations over the fact that USA kept their AAA credit rating for years despite having an unsustainable deficit. Another criticism thrown at the credit agencies is that their downgrades can become a self-fulfilling prophecy, with Greece, Portugal and Ireland’s debt crises accelerated after being downgraded. This gives the agencies a lot of power over markets; their mistakes can lead to some very negative outcomes and the fact that the big three agencies rarely agree means there must be errors in their decisions. Another criticism is that the bad debt that helped crash the markets in 2007 (sub-prime mortgages) was given AAA rating when it was pooled together, leading many investors to buy into it. The fact they are paid for their services means they can’t be impartial, especially when they are paid by the firms they are investigating. Europe has been critical during the euro crisis, stating the agencies have been too quick to downgrade countries with Greece, Portugal and Ireland given “junk” statuses in 2010. This argument flared up again in 2011 when Standard & Poor announced any restructuring of Greek debt would be classified as a default.

To conclude, maybe one day we won’t have to be so reliant on a few credit rating agencies to rule the markets, maybe investors could decide for themselves whether particular debt had too much risk and maybe… maybe one day our markets won’t be too reliant on debt in the first place, though that day seems a long while off.

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Kane Prior

My name is Kane Prior and I like to write about economic issues from around the World. I am a graduate from the University of Kent with a 2.1 degree in Business and Economics. I hope to use this blog to gain interest in myself and maybe lead to some potential career someday. If you want to contact me I am on Twitter (just click on the image) and if you have any writing opportunities for me, then please feel free to drop a message.

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